Question

Q1) Explain the following -

1) Absolute Income Hypothesis

2) Life Cycle Income theory

3) Permanent Income Hypothesis

Answer 1

Answer 1 : Absolute Income Hypothesis

As we know that consumption function is the relationship between consumption and income.

Absolute Income Hypothesis states that, As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the MPC decreases. Absolute Income Hypothesis is originated by Keynes. An increase in disposable leads to an increase in consumption - people will spend a portion of each additional dollar of disposable income earned.

Marginal propensity to consume(MPC) is the ratio of the change in consumption spending to a given change in income.

Answer 2 :- Life Cycle Income theory

Life cycle income theory states that People save primarily to provide for consumption during their retirement years.Albert [Ando] and Franco [Modigliani] are Contributor to Life-Cycle Income Hypothesis.

The average propensity to consume is higher in young and old households, whose members are either borrowing against future income or running down life-savings.

Middle-aged people tend to have higher incomes with lower propensities to consume and higher propensities to save.

According to Modigliani's life-cycle hypothesis, if a consumer wants equal consumption in every year and the interest rate is zero, then the marginal propensity to consume out of wealth increases as years of life remaining decrease.

Answer 3 :- Permanent Income Hypothesis

Permanent Income Hypothesis is originated by Friedman. It states that throughout their lifetime, people will consume from their permanent income and save their transitory income.

According to the permanent-income hypothesis, if consumers receive a permanent increase in their salary then they will spend most of it in the current year. If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will increase when they receive an unexpected inheritance. If consumers obey the permanent-income hypothesis and have rational expectations, then policy changes affect consumption when the policy changes change expectations.

The life-cycle hypothesis and the permanent-income hypothesis both assume that consumers seek to smooth consumption over their lifetimes.